Interest Rate Impact
We wanted to talk to you about the size of the Federal Reserve balance sheet. What are the two main ways in which the Federal Reserve impacts the economy? The first is likely the one you are probably most familiar with. If interest rates go up, the cost of capital is higher and if interest rates go down, the cost of capital is lower.
Balance Sheet Impact
While the impact of interest rates is the commonly discussed in the media you could see another impact that will start to come to life in the upcoming weeks. That impact is the size of the Federal Reserve balance sheet. This has become a more important topic since 2008. What our Federal Reserve does, opposed to other central banks around the world, is our Fed has what’s referred to as a two-prong mandate. It manages the economy through interest rates and tries to manage the employment number. Many others focus on just one or the other. Our reserve is unusual in that they try to do both. They do this through interest rate change and balance sheet size.
A Look Inside
The Fed’s balance sheet is like any other company you can think of in that you have assets and liabilities. If you look at the Fed’s balance sheet you will see the assets they hold consist of mortgage bonds, US Treasuries and a small collection of other items. If you look at their liabilities you will find currency in circulation, reserve balances and the US General Treasury Account.
The Federal Reserve, in terms of their total balance sheet size, was only around $1 trillion just before the financial crisis of 2008. That amount has quadrupled since that time. One of the reasons for this is because the US has an active capital markets group or, in other words, commercial paper. If you look at other areas such as Europe you will find they more of a traditional banking system. If they need capital for their company they usually go down to the bank to borrow it. In the US we can both borrow from a bank or companies can finance themselves through an open commercial paper market.
Impact on the Economy
What the Fed in the US can do is essentially give it liquidity in the way that it can grow better and faster. The benefit of our Federal Reserve is we can grow the balance sheet by putting a lot of cash in the system. This was historical in 2008 as we have discussed in many previous vlogs. Since then our economy has gotten better and we have started to shrink the balance sheet with assets reaching around $4.5 trillion at one point and lingering around $4 trillion now. We were on a fairly steady schedule with the Fed of reducing the balance sheet back down. In terms of keeping our economy efficient we could see some discussion from the Fed to level off in order to veer away from the current decrease trend we are on. The reason for this is when the Fed owns more US treasury in the system it has the tendency to help US economic growth. So, in addition to interest rates that you probably more familiar with, the Fed can also impact the economy by how big its balance sheet is, similar to any other company.
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